This is an extended version of an opinion piece published in the Irish Examiner 12 November 2011
With every week that passes it is becoming unfortunately clear that under present arrangements the euro cannot continue. We have seen political dithering of the worst kind, persistently, with the resulting vacuum in terms of policy being taken up by the European Central bank. Although one can criticize the ECB for many of its activities (not least the bewildering refusal to contemplate the other side of the fence in relation to Anglo) is to its credit that has at least stepped into the breach. However of all of the European institutions it is probably the least democratic, as independent central banks have to be. Every ECB action, no matter how well-meaning, in the absence of political and therefore democratic-based approaches further undermines the democratic legitimacy of the euro. Trust in the ECB has and will continue to dwindle. In any case ECB intervention in bond markets has at best only a temporary effect, and it is ultimately up to governments at national and European level to implement policies that restore fiscal discipline. The academic research on bond yields is thus while in the short term like any asset they can be moved by speculative positions in the medium and long-term contract very well against economic fundamentals.
The action this week has focused on Italy. Heretofore the countries that have found themselves locked out of the financing markets have been ones, which were sustainable, non-systemic, and manageable. Italy is simultaneously too big to fail and too big to save. Italian Public debt is the third-largest, in absolute terms, in the world: it has to refinance €200 billion in the next year: GDP is the eighth largest in the world. And yet this week we have seen that Italy is, in effect, locked out of the bond markets, at least anything approaching sensible rates.
We also see this week that, despite there being no formal mechanism for doing so, it has been suggested by leading European officials and politicians that countries can exit the Eurozone. It is highly probable that an exit by any country would lead to a cascade, resulting in the effective breakup of the euro. What then for Ireland?
The first thing that must be said is that hopefully somewhere in government there is a plan. Governments should plan for all eventualities. Planning to deal with an eventuality is not the same as wishing for same; failure to plan could be catastrophic. The historical evidence is not good that there is a coherent, competent analytically sound plan cooking in the Dept of Finance
Secondly in the event of the euro breaking up, which may be as a result of the Cascade outlined above or perhaps due to the German political system not being able to persuade itself or its constituents of the need for Germany to accept that it is going to have to foot the bill, there will be significant winners and losers in Ireland. In a first decision that would have been made by the government would be whether or not in the event they would allow a freely floating currency, which would almost certainly depreciate significantly, or whether they would put in place some form of managed float. While depreciation would be attractive, in that it would be a boost to exports and therefore assist in putting the country back on a growth path it would also result in imports becoming more expensive. A third of our imports come from the United Kingdom, and in all likelihood the new Irish pound would be weaker than sterling. It was also likely to be weaker than the dollar, which given our extreme dependence on imported oil would result in significant increases in the domestic price of petroleum based products. All of these would rise in price, importing inflation and penalising businesses and consumers.
We will also have to very quickly move to achieving a primary surplus. The primary surplus instead of a primary deficit in government finances would be necessary in order to pay down the accumulated national debt. When we consider the pain that we are going through in order to reduce the deficit to 3% over four years is hard to imagine the wrenching dislocation that would be required to achieve a primary surplus over a couple of years. Yet that would be what would be required. We would have to offer significantly higher rates on our debt to potential investors than is the case even know, not least because they would almost certainly be facing into a much more inflationary environment. Bond yields (see here and here for example) Are in large part driven by fundamental economic factors.
Another issue where there would be mostly losers, would be around external euro denominated liabilities. External in this context means outside of Ireland. Mortgages, bank loans, any liabilities within Ireland would be converted to the new pound. It is the liabilities in euros outside Ireland that would be messy. The most likely option would be that these would be dominated into the currency of the country where they are located. Thus a loan taken out in Germany would be converted into Deutschmarks, which would result in a very significant increase in in these liabilities. conversely for multinationals with money on deposit in Ireland, and this amounts to billions of euros, any hint that these would be likely to be converted into a weaker currency would result in their being withdrawn. This in turn would exacerbate the existing credit crunch. The only feasible solution would be harsh exchange controls and a degree of financial repression for a time.
A possible area of concern is around banks dependence on ECB funds, which although declining, is still very high. Absent the ECB the central bank of Ireland would have to step into the liquidity breach, further exacerbating inflationary fears. On the positive side it would be much easier to restructure the Anglo promissory notes.
It is debatable whether or not Ireland should have joined the euro. At the time I was in favour, more from political economy perspective than a pure economics perspective. I felt at the time that on balance European politicians were more likely to behave in an economically sensible manner than Irish politicians, and that the requirement as part of a monetary union from fiscal discipline would be useful for Ireland. Unfortunately this faith was misplaced on both sides.